Unintended Consequences, Part 1: Bigger Deficits = Higher Interest Rates =…Many Bad Things

Mainstream economics uses a fairly simple equation when it comes to public policy: More government spending equals more growth, which is just about always a good thing.

The problem is with the “just about always” part. At the bottom of recessions, tax cuts and higher government spending can indeed stop the shrinkage and get things going again. And fiscal stimulus might be relatively harmless when an economy has minimal debt and can therefore handle a bit of deficit spending without negative side effects.

But this is not one of those times. Eight years into a recovery, with unemployment and interest rates at near-record lows and global debt at record highs (by a wide margin), borrowing a ton of new money virtually guarantees rising inflation and shortages of everything from trained workers to copper and zinc. To which the Fed is pretty much required to react:

Spending Bill Raises Expectations for More Fed Rate Increases

(Wall Street Journal) – A bipartisan spending deal reached by U.S. lawmakers earlier this month has prompted many Wall Street economists to raise their projections of how much the Federal Reserve will raise interest rates this year and next.

More forecasters say they now expect four Fed rate increases this year, up from three, because of the deal to increase federal government spending by $300 billion over the next two years.

The funding bill is more generous than many economists anticipated, and they predict it could boost U.S. economic growth in 2018 and ’19 by around 0.3 percentage points each year—roughly the same size increase expected from the $1.5 trillion tax cut signed into law by President Donald Trump in December.

Economists at UBS Group AG, Nomura Securities and Oxford Economics in the past week raised their projections for rate increases, joining other prominent forecasting shops that had already projected four quarter-percentage-point increases in the Fed’s benchmark short-term interest rate this year.

Nomura sees the Fed raising rates four times this year and twice next year, adding one more additional rate rise to its forecast in both years. UBS also added one rate increase to its forecast each year, now expecting the Fed to raise rates four times this year and three next year.

Economists at Goldman Sachs Group Inc. and JPMorgan Chase & Co., which were among those already projecting four rate rises this year, have said the government spending package makes them more confident in those calls.

What’s wrong with deficit-led growth pushing up interest rates a bit? History, for one thing. Note how a rising Fed Funds rate preceded every recession in living memory. AND that the point at which higher short-term rates kicked the economy into reverse has been lower in each post-1980 cycle. So it’s reasonable to assume that in the current hyper-leveraged system it won’t take much higher rates to produce instability.

The question then becomes “what is the magic – or tragic – number that sets off the next conflagration?” That’s unknowable, but given the pattern of the past few decades it appears to be south of 5%. Another four quarter-point hikes gives Fed Funds a 3-handle, which may or may not do it but is definitely getting close.

Meanwhile, long-term rates are reacting aggressively to the prospect of wage and raw material inflation. The 10-year Treasury yield took off when the Trump tax cuts became feasible and hasn’t looked back:

Now it’s getting harder for the US to convince people to buy its paper at current rates:

Treasury Seven-Year Sale Caps $258 Billion Week of Higher Yields

(Bloomberg) – The U.S. Treasury’s $29 billion auction of seven-year notes drew the highest yield for securities at that tenor since 2011, capping a $258 billion flood of debt sales over three days.

As with the week’s other note offerings, there was a dip in the amount of bids relative to the amount sold, signaling weaker demand. With the Treasury ramping up borrowing as part of its plan to finance widening budget deficits, the auction was $1 billion larger than it was last month and the bid-to-cover ratio slid to 2.49 from 2.73 at the prior sale.

Indirect bidders, a class of investors that includes pensions and mutual funds, purchased 62.2 percent, down from 78.1 percent last month. Direct bidders, on the other hand, bought 15.6 percent, the largest share since September. The securities were priced to yield 2.839 percent, the highest since March 2011.

All told, the auctions show that there’s demand out there for Treasuries, even as supply ramps up, but investors may require higher yields to step in and buy.

Courtesy of https://dollarcollapse.com